Eurozone Relief Doesn’t Mean Resolution

New steps toward resolution in the Eurozone debt crisis have eased fear and uncertainty, but a possible recession and lofty European bond yields are among the key issues that will impact world currency markets in the near term.

The political uncertainty in Greece has eased as a new technocratic government was sworn in on Friday. The new government is led by former European Central Bank (ECB) Vice President Lucas Papademos, and Venizelos held on to his post as Finance Minister and Deputy Prime Minister. Government officials said the nation’s first priority is to secure the payment of the sixth tranche of aid, which provided clarity and reduced fears of an imminent default.

In Italy, the upper chamber approved austerity measures and the lower house is scheduled to vote in Rome. The developments point towards new leadership in Italy as Prime Minister Silvio Berlusconi pledged to step down after the approval of the debt-reduction measures. Expectations are for Italy to follow Greece in establishing a technocratic government with Mario Monti as the likely head.

While recent developments have seen risk sentiment stabilize and the EUR advance heading into the weekend, it is unlikely the rally will be sustained, as structural challenges and lower growth outlooks pose downside risks to sentiment.

It is also of note that in the coming weeks, US politics may come into focus with the deadline for the supercommittee approaching. The joint select committee is tasked with issuing a plan to slash the deficit about $1.5 trillion over a ten-year period by Nov. 23.

See video: Will the Supercommittee Succeed?

…But Growth Concerns Remain in Focus

This week saw slowing industrial production and retail sales in the world’s second-largest economy. The data supported our view of a soft landing in China, as growth is expected to moderate and may weigh on currencies such as the AUD and NZD, which are linked to global growth.

The economic recovery in the US remains weak, however, recent data has shown a pickup in the pace of growth to 2.5% quarter-over-quarter (q/q) annualized GDP growth in Q3 from the prior +1.3% in Q2.

The European Union cut its growth forecasts for 2012 and noted that the region could face a “deep and prolonged recession.” In its semi-annual forecast released this past week, the European Commission (EC) reduced its forecast for growth in the Eurozone to 0.5% in 2012 from the previous forecast of 1.8%, which was released in May. The commission cited financial turmoil, government austerity packages, weak confidence, and slowdowns in external economies that trade with Europe as reasons for the bleak outlook.

While growth is expected to be slightly positive next year, this does not mean that the EZ may see a brief recession. A technical recession results from two consecutive quarters of negative economic growth. Many central bankers including ECB President Draghi have stated their expectations for a European recession. At his first policy-setting meeting as ECB President, Draghi noted that Europe is heading towards a "mild recession."

NEXT: Latest on Sky-High European Bond Yields

Recent manufacturing PMI readings out of Europe have printed below the key 50 level, indicating contraction, and in the week ahead, 3Q advance GDP figures will be released. On Tuesday, Eurozone GDP growth is expected to slow to 1.4% year-over-year (y/y) from the prior 1.6%. The consensus for Germany’s 3Q GDP to be released on Tuesday is for growth of 2.5%, and France’s figures (which last showed no quarterly growth) are released the same day. The EC said in its statement that the disparities between member countries are expected to widen next year.

It will be important to watch the trajectory of growth in the Eurozone as a recession looms and as the ECB has shifted towards more of a focus on growth. At the last ECB meeting, the decision to cut rates was defended by weakening economic data and the idea that sluggish growth may dampen inflation pressures.

Continued weakness in growth is therefore likely to see market price further policy rate cuts, which in turn will weigh on the EUR in the longer term. As such, next week’s Eurozone inflation figures, which are expected to show CPI remaining at 3.0%—well above the 2.0% target—may not have the impact as Trichet is no longer heading the Bank.

More importantly, growth is needed to allow the debt-laden countries to reach sustainability. The prospect of contracting growth not only raises debt-to-GDP ratios, it reduces the ability to finance debt burdens—a major factor in negative sentiment towards the common currency.

Peripheral Bond Supply Is Increasingly Significant

Sovereign bond yields in Europe have been watched closely of late as an indication of sentiment towards the ongoing debt crisis. The Italian ten-year yields spiked to highs of nearly 7.48% as markets expressed nervousness over the ability of the country to fund itself, but the yields have since pulled back over 100 basis points (bps) to current levels of around 6.45%.

French ten-year yields also shot higher this past week following an erroneous statement from S&P that the nation’s credit rating had been downgraded. Shortly after, a correction was released and the ratings agency confirmed that France’s rating remained AAA with a stable outlook.

In the week ahead, there will be auctions from Italy, Spain, and France. Traders will be watching closely to determine the sovereigns’ ability to fund themselves as well as to gauge investor appetite. In the scenario that demand comes in weak and yields surge, the EUR is likely to suffer as the correlations have risen significantly over the past few weeks.

By Brian Dolan, chief currency strategist, FOREX.com